Michael Johnston: As the ETF universe has expanded by leaps and bounds in recent years, investors now have tools at their disposal to accomplish almost objective. From plain vanilla stock and bond indexes to hyper-targeted regional and sector funds, there are ETFs to bet on just about every asset class.

And there are also a number of ETFs that can be used to bet against certain asset asset classes, which can be powerful tools for turning a profit in the types of environments that generally bring a sea of red ink to portfolio statements. Inverse ETFs, also known as short ETFs, have become extremely popular for a wide variety of objectives, including as hedging tools and vehicles for speculating on declines in value [see Free Report: How To Pick The Right ETF Every Time].

Short ETFs 101

Short or inverse ETFs generally seek to deliver results that correspond to the inverse, or -100%, of the movement in a specified index over a given period of time. The last part of that objective is critically important to understanding the risk profile offered by these products; inverse ETFs strive to deliver the target multiple (i.e., -100%) over a specified period of time, which is generally a single day. When held for longer periods of time, inverse ETFs will not always deliver returns that correspond to the opposite of the underlying index over that period of time.

This isn’t the result of a deficiency in these products, but rather the result of simple arithmetic. It’s the exact same phenomenon that plays out in traditional long ETFs, but with a subtle twist for inverse exposure [see The Definitive Inverse ETF Guide].

To understand this nuance, consider a hypothetical example in which a stock index alternates between gains of 5% and losses of 5% for ten consecutive days:

Day

Opening Value

Change

Closing Value

Day 1

$100.00

5.0%

$105.00

Day 2

$105.00

-5.0%

$99.75

Day 3

$99.75

5.0%

$104.74

Day 4

$104.74

-5.0%

$99.50

Day 5

$99.50

5.0%

$104.48

Day 6

$104.48

-5.0%

$99.25

Day 7

$99.25

5.0%

$104.21

Day 8

$104.21

-5.0%

$99.00

Day 9

$99.00

5.0%

$103.95

Day 10

$103.95

-5.0%

$98.76

After ten days, the index is down about 1.24%.

Now consider an inverse ETF linked to that index, meaning that the product seeks to deliver daily results corresponding to -100% of the underlying index. The performance of that ETF would look something like this:

Day

Opening Value

Change

Closing Value

Day 1

$100.00

-5.0%

$95.00

Day 2

$95.00

5.0%

$99.75

Day 3

$99.75

-5.0%

$94.76

Day 4

$94.76

5.0%

$99.50

Day 5

$99.50

-5.0%

$94.53

Day 6

$94.53

5.0%

$99.25

Day 7

$99.25

-5.0%

$94.29

Day 8

$94.29

5.0%

$99.00

Day 9

$99.00

-5.0%

$94.05

Day 10

$94.05

5.0%

$98.76

If you expected this inverse ETF to be up slightly (since the underlying index was down since purchase), you might be disappointed. After ten days, the inverse ETF is also down 1.24%, which occurs because of the volatility in the underlying index. When markets seesaw back and forth between gains and losses, inverse ETFs can experience some “return erosion.” That’s because ahead of a winning session for the inverse ETF, exposure is decreased (through a loss in the previous session), and vice versa. In back-and-forth environments, the daily reset works against these funds.

It’s also extremely important to not that the compounding of returns doesn’t always work against investors in short ETFs. Consider a trending market where the underlying index steadily loses ground:

Day

Opening Value

Change

Closing Value

Day 1

$100.00

-5.0%

$95.00

Day 2

$95.00

-5.0%

$90.25

Day 3

$90.25

-5.0%

$85.74

Day 4

$85.74

-5.0%

$81.45

Day 5

$81.45

-5.0%

$77.38

Day 6

$77.38

-5.0%

$73.51

Day 7

$73.51

-5.0%

$69.83

Day 8

$69.83

-5.0%

$66.34

Day 9

$66.34

-5.0%

$63.02

Day 10

$63.02

-5.0%

$59.87

After ten sessions, the index is down about 40%. But the inverse ETF linked to this index would end up posting a gain much larger than 40%:

Day

Opening Value

Change

Closing Value

Day 1

$100.00

5.0%

$105.00

Day 2

$105.00

5.0%

$110.25

Day 3

$110.25

5.0%

$115.76

Day 4

$115.76

5.0%

$121.55

Day 5

$121.55

5.0%

$127.63

Day 6

$127.63

5.0%

$134.01

Day 7

$134.01

5.0%

$140.71

Day 8

$140.71

5.0%

$147.75

Day 9

$147.75

5.0%

$155.13

Day 10

$155.13

5.0%

$162.89

In this case, the daily compounding of returns gives a significant boost to the inverse ETF, which realizes a gain that is considerably larger than the decline in the index. That’s because as the index declines, the value of the short ETF increases. Each subsequent daily gain for the short ETF is then applied to a larger and larger base of assets, which results in a very favorable compounding of returns.

Monthly Short ETFs vs. Daily Short ETFs

There are some inverse ETPs that seek to achieve their results over a period of time that is longer than a single trading session. Specifically, PowerShares and Deutsche Bank offer a number of ETNs that seek to deliver results equal to -100% of indexes comprised of commodity futures over the course of a month. These products won’t be impacted by the direction of the underlying index between reset periods, meaning that the impact of day-to-day volatility won’t result in eroded or enhanced returns as illustrated above [see alsoETFs To Smooth Volatility: Looking At Some Long/Short Options].

With monthly inverse ETNs, it should be understood that the target multiple (i.e., -1x) applies only at the start of the month, and will generally change as the month progresses. In other words, investors who buy in mid-month to a product such as the PowerShares DB Gold Short ETN (DGZ) could be achieving effective leverage for the remainder of the month that is greater or less than -100% [see alsoGreedy When Others Are Fearful ETFdb Portfolio]. At the end of each month, that leverage is reset and DGZ will begin its objective over again (i.e., seeking to deliver inverse exposure over the next calendar month).

Short ETFs vs. Shorting An ETF

One common misconception about short ETFs is the notion that they will deliver an investing experience that is substantially similar to short selling a traditional ETF. While there are some general similarities in the risk profiles that result, there are a number of differences as well. Perhaps the most significant relates to the phenomenon of compounding returns, as highlighted above.

When a stock is sold short, the short seller is essentially borrowing an amount of money equal to the share price, with the obligation to repay that “loan” at some future date in the amount of the value of the underlying security at that time. Short selling essentially involves selling a share that you don’t own. Generally, the share is borrowed from another customer account at your brokerage. Eventually, you must close out the short position by purchasing the share and returning it to the portfolio of the original owner. If the security declines in value, you’ll be able to make that purchase at a lower price and keep any difference as profit–effectively paying off a debt for less than the original value. If the price rises, you’ll end up paying more than you initially borrowed [see How To Play A Treasury Bubble With ETFs].

Investing in inverse ETFs is obviously quite a bit different. Investors must have the capital to purchase the inverse ETF, and there is no borrowing of shares involved when establishing a long position in a short ETF. It should also be noted that inverse ETFs have a known amount of downside risk at the time of purchase; investors can lose no more than their initial investment (which would happen if the price of the ETF goes to zero). Shorting an ETF (or any security for that matter) can expose investors to a significant amount of risk; if the value of the underlying security skyrockets, their losses can be multiples of the initial amount the received by shorting the security.

Short / Inverse ETFs For Popular Indexes

There are dozens of inverse ETFs now available to inverse investors, including several linked to the most widely followed indexes in the world:

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